The leverage crash and short interest.

Ask any PGA golfer, and he will tell you that bad shots often lead to even worse shots. This is because the first shot leaves you in a worse position than before, perhaps behind a tree, in thick rough or in a sand trap. The next shot is invariably worse because the golfer tries to pull off an exponentially more difficult shot that exceeds his talent, resulting in an even worse position.

With regard to the SEC’s action regarding short sellers, I believe Chairman Cox is no Tiger Woods. Here is the position short sellers find themselves in:

1. Ban on Short Selling – Part Deux

Despite the miserable failure of the Ban on Short Selling – Part 1, which was the temporary July 21st ban on 19 financial stocks that was designed to protect them from “rumor mongers,” the government has decided to try that shot again, going for even more distance by banning short selling of 799 financial stocks. Interestingly, these 799 do not include RIETs, some asset managers and insurance brokers that are key operators in the current financial debacle. Also missing are certain companies that act like banks, e.g. General Electric (GE), General Motors (GM), and Ford (F). Regardless, it can hardly be the case that short selling in financial companies flew in the face of sound fundamental analysis. Bear Stearns, Lehman Brothers, Fannie Mae (FNM), Freddie Mac (FRE) et al can't blame short sellers for the mess they found themselves in.

By further restricting the short selling of these 799 institutions, there are a host of consequences. The mother of all short squeezes is underway, not because these short sellers made an incorrect fundamental bet, but because of government intervention. Their fate is now sealed, but other short sellers, hedgers and speculators alike must now ask themselves whether they can rely on a financial system fraught with regulatory uncertainty. To sell short in an environment where the government can change the rules on you literally in the dark of night does not instill confidence in a financial system. Most are aware of the liquidity and hedging benefits that short selling provides any marketplace. Today, short sellers are now operating in a market structure environment equal to the uncertainty of Third World markets.

The irony here is that the short covering that we're seeing today is contributing to higher stocks prices in this morning’s action. A short squeeze is a short squeeze no matter the underlying cause. In a normal world, short squeezes are the result of negative bets on companies that fundamentally are improving. In today’s world the shorts are forced to cover in a panic response to government spasms of regulatory intervention. There is a huge unintended consequence here. Once the short sellers are gone, there will be a cavernous gap between the short covering demand for stock and the demand for stock based upon fundamentals. This vacuum will create a precipitous long squeeze. We saw it in Fannie Mae.

The above chart shows the price action in Fannie Mae at the various stages of the original ban on short selling. The stock price got a big bounce after the announcement of the ban, but actually topped out intraday on the day the ban was enforced. By the time the ban was lifted, the price action, reflecting fundamentals, dropped back down to its lows and plummeted thereafter.

My point is that any artificial removal of short sellers from a market does irreparable damage to the trading outlook for that market. If for no other reason, this is true because the extra buying that potential short covering represents no longer exists. Short sellers actually add friction to a slide precisely because they represent an exogenous pool of buyers. Nothing is sweeter than seeing the shorts proven wrong by the marketplace. However, imagine the outcry if stockholders were forced to sell a stock about to double in earnings because the government arbitrarily banned any long positions in this stock based upon misguided scenarios.

2. Institutional money managers must report their new short sales of certain publicly traded securities.

The SEC is now temporarily requiring that institutional money managers report their new short sales of certain publicly traded securities. These money managers are already required to report their long positions in these securities.

This sounds like a good thing, but the idea that a short seller can be identified can have consequences. Imagine if Warren Buffet sold XYZ stock short, and the world, discovering this from the public reports filed with the SEC, piles on and crushes the stock as shorts pile on and longs sell at the market. Yikes!

There is also the consequence of retaliation by the companies being sold short. Lawsuits, black lists, etc. come to mind.

In my opinion, all of the concerns stemming from the action of short sellers originate from Chairman Cox’s first poorly placed golf shot – the elimination of the uptick rule for short selling.

Over a year ago, in my monthly (July 2007) report, I stated:

“…we are concerned that SEC Chairman Cox is a bit premature in calling the uptick rule “antiquated.” In the regulation SHO pilot test started in 2004, where short selling on downticks was allowed, no major stock market decline occurred. As money managers adopt strategies that include short selling, we think the lack of an uptick rule could exacerbate market meltdowns.

Here’s a thought. Restrictive securities regulation most often occurs after market meltdowns. The Securities Act of 1933 and the 1934 formation of the SEC itself was a result of the market’s collapse into 1931. The SEC tried to gain control of the equity derivatives markets from the CFTC after the Crash of 1987… and whatever happened to those circuit breakers enacted by the exchanges? Buying into those times (1933, 1934 and 1987) were great entry points. So, does the unwinding of securities regulations, like the uptick rule, mean we are at the other end of the market spectrum?"

The latter was an interesting question. Certainly the market has declined sharply since that report. Can we say that today represents the other side of the greed/fear spectrum? Where is the big barf, as we like to call it? We do believe the market registered real fear. We saw it in the VIX rising above the 40 level. We really saw it in the swings of gold this week.

So traders are faced with a dilemma. Are the fundamentals really changed by the mix of government intervention, or has their action served only to remove the fear, and not the problems fundamentally facing the markets?

At the end of the day the market will tell us, especially if the averages can forge ahead of their monthly DMA channels. Our concern is that the fear in the marketplace has been artificially removed without the benefit of improved fundamentals, and that there will be no one left to take the fall if the market backslides once more in response to the “leverage crash” that is fundamentally underway. Stay tuned!

No positions in stocks mentioned.

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